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The Science of Hitting
The Science of Hitting
Articles (401) 

Avoiding a 10 Year Mistake

February 02, 2012 | About:

In “Value Investing” by James Montier, arguably one of the best books even written about investing, there is a chapter entitled “Maximum Pessimism, Profit Warnings and the Heat of the Moment”. In the chapter, Mr. Montier discusses empathy gaps, which is a bias that causes people to underestimate how we will behave/feel in the future, particularly during moments of stress/emotion; one great example of this is a test performed by Dan Ariely and George Lowenstein at the University of California.

In the experiment, they asked 35 male students to rate how likely they were to find a certain act (spanking, for example) to be sexually stimulating, but under two different scenarios; one was during a routine moment of one’s day, while the other occurred when the subject was at home while enjoying “self-gratification” (for lack of a better term). What the researchers found was that during the light of day, the average rating was 35%; however, when the survey was completed at home, the average rating jumped to 52%.

The purpose of this story is to show that it’s hard to predict how we will act under pressure, in the "heat of the moment"; in the markets, that usually means when the sky is falling. Because of this bias, many will fail to act rationally, resulting in a rare opportunity for intelligent investors; in the words of Sir John Templeton, “The time of maximum pessimism is the best time to buy”.

This brings me to a bit of history that was created on Thursday: Procter & Gamble (PG), the world’s largest consumer products company, issued $1 billion in 10 year bonds at 2.3% this week, the lowest rate ever for 10-year corporate bonds according to Bloomberg. William Larkin, a fixed-income money manager at Cabot Money Management in Massachusetts was quoted in the article as saying, "This is free money.”

For investors buying this offering, they are happily entering into what appears to be a long term disaster; with the CPI running around 3%, they are essentially locking themselves in for a decade of negative real returns (assuming inflation levels remain unchanged). Without looking any further than P&G’s equity, they are also passing up on a company that increased its dividend 9.5% annually for the past half century, and currently yields more than 100 basis points than the fixed rate bond.

In my mind, there is no justification for scooping up 10-year fixed rate bonds, especially when viewed relative to the other ways one can currently build an equity portfolio to generate income and still replicate the benefits (particularly in a state of deflation) generated in a fixed income strategy.

There have been eight recessions (by definition) since 1950, and none of them managed to slow the growth of Procter & Gamble’s first class innovation and products; the same can be said for PepsiCo (PEP), Coca-Cola (KO), Johnson & Johnson (JNJ), and Nestle (NSRGY), among many others. This time isn’t different, even though it may feel as such in the heat of the moment.

About the author:

The Science of Hitting
I'm a value investor with a long term focus.

I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."

I run a fairly concentrated portfolio, with 2-5 positions accounting for the majority of my equity portfolio. From the perspective of a businessman, I believe this is sufficient diversification.

Rating: 4.3/5 (26 votes)



Benethridge - 4 years ago
“The time of maximum pessimism is the best time to buy”

That's such an easy thing to say...in hindsight. Here's one that others might say:

"The time of maximum pessimism is the time to head for the nuke shelter."

You see, with a bit of bad luck, we could have easily lost WWII.

One thing Templeton may have known intuitively, is that investors tend to over-react to bad news, and therein lies an investment opportunity. This has been confirmed by psych research and is the ONLY reason I would agree with Templeton's statement....but it SO hard to do, when the Nazi subs are sinking ships right off the coast of Florida.


Ry.zamora - 4 years ago
Obviously, being a contrarian can also kill you if you're not scrutinizing enough. Value traps exist and, on top of it, even if you are right in the end, the markets can remain irrational longer than you can be solvent (to paraphrase another famous quote).
The Science of Hitting
The Science of Hitting premium member - 4 years ago

It certainly is hard; as Munger has said, it doesn't take many, but when you have those few opportunities you MUST load up with conviction. As you say, it's easier said than done, and explains why 99.99% of people haven't attained investment results anywhere near what Warren & Charlie have.


Certainly you must scrutinize investments, which is why staying within your circle of competence is so critically important. In regards to solvency, you should only invest with the understanding that the capital being committed will be locked up for years to come, and avoid leverage; if these rules are followed, it's almost certain that you can outlast any bout of irrationality in the markets.

Ry.zamora - 4 years ago
I think that merely staying with your circle of competence inhibits you from personally growing and becoming flexible. If you find something beyond your circle, then MAKE IT your circle of competence.... and you just move on if you can't understand it or you can't construct the tools needed to scrutinize it.

We're all playing the game to make money, for ourselves or for our clients. As a value investor, our job is to maximize return while minimizing risk, over the long run. It doesn't matter if you're using your own portfolio or a mash of your money and your clients'. Opportunities are everywhere and seeking them out might mean venturing beyond one's comfort zones.

it's almost certain that you can outlast any bout of irrationality in the markets.

I understand that outlasting irrationality can be done by focusing on the LT and avoiding leverage -- both in your investments and in your funding. That's a given.

My concern is, won't lifetime performance be deterred if one holds it for too long and the price makes no movement towards the computed value estimates, even during "peaceful" times? Choosing to lock up capital has opportunity costs, as is forgoing it or selling it (at a profit or loss). :)
The Science of Hitting
The Science of Hitting premium member - 4 years ago

I agree with you; obviously, an individual should continue to expand their circle of competence. My point was that it's much more difficult to spot a value trap when you're treading in unknown waters; investors can get in a lot more trouble by going outside the circle of competence rather than from being contained within a smaller universe of potential investments.

Personally, I think venturing outside of your comfort zone is a big mistake. If you take the time to learn about the industry and have a complete understanding of the factors in question, more power to you; most people trick themselves into believing they understand what's going on (like with banks), and only realize in retrospect that they didn't have a clue about what was really going on. For investors who bought BAC in the low-mid teens in 2011, this is a lesson that many of them have probably experienced first hand.

Your last point is spot on, and one of the problems with pure Ben Graham type value plays: if you buy something at a 50% discount to intrinsic value, whether or not it becomes a good investment is dependent upon the time it takes for price to converge with value. If it takes six months, that's a fantastic investment; if it takes six years, not so much.

My personal feeling is that investors should buy great businesses (i.e. those that are continuing to increase their intrinsic value over rolling 3 year periods) at fair prices, rather than fair businesses at great prices, mainly because of the reason you stated. If you can find a cheap business that is increasing it's intrinsic value (like MSFT in the mid-20's), that's a big opportunity that the intelligent investor should recognize and look to capitalize on in a big way...
Benethridge - 4 years ago
Hmmm... if everyone bought great businesses at fair prices, what do you suppose would happen to the price of all the not-so-great-but-not-so-bad-either businesses?

Seems like there is room for every type of investor at the party, yes?
The Science of Hitting
The Science of Hitting premium member - 4 years ago

This is true; if everyone flooded high quality stocks, then this phenomenon could play out. Yet today, that idea appears to be far different from reality; investors are now willingly choosing to buy 30 year treasuries at yields below those of companies like Procter & Gamble, which has paid a higher dividend (an increase of roughly 9.5% per annum) each and every year for more than half a century. Obviously, this doesn't mean that lower quality equities aren't a value as well (as you contended).

At the end of the day, you must make the price-to-value calculation; my point was that if you are forced to wait 5 years for those to figures to convergence, it's nice to be nearly certainly that the "value" portion of the equation will increase over time...
Benethridge - 4 years ago
I agree. As I recall from Phil Fisher's book, he usually concluded that he had made a mistake if the figures didn't converge by 3 years time. Of course, he's not taking into account any more Nazi subs off the east coast, i.e. like Buffett, he's intentionally ignoring all the macro s#*@ that could possibly hit the fan in the next 3 years. I think you just have to do that to be an investor (kinda to your point, I believe). Investors ("investing" in the "future") just have to be optimistic that the world won't blow apart before they finish out their long, happy, rich lives. :-)

Buying stocks the Phil Fisher way takes a LOT of time and energy, so most people don't have the time, energy or patience to do it...but it's the only "businesslike" way to invest, IMHO. Essentially, he demands that you expand your circle of competence to include the business you are buying BEFORE you buy.

The Science of Hitting
The Science of Hitting premium member - 4 years ago
You don't have to be optimistic, you have to be realistic; very, very, very few people can forecast macro events for a long enough period of time to actually profit from it, and many of them are probably just lucky. The point is that you should focus on what you CAN know, and not spend your time worrying about what you CAN'T know.

The most important thing is that great businesses have competitive advantages and the fortress balance sheets to withstand the unknown; there is a reason why KO, JNJ, PG, and others have survived The Great Depression, WW2, The Great Recession, and plenty of other "the end of the world" moments in between. This says something about these businesses, their competitive positions, their balance sheet conservatism, and their staying power; for the investor, these revelations should not be overlooked, especially considering that all three have paid dividends for decades, uninterrupted.

On the circle of competence comment, I agree with you 100% Ben; expanding your circle of competence is a great idea, just don't trick yourself into believing that you know more than you really do.
Benethridge - 4 years ago
I agree. I think we're saying the same thing, i.e. we have to ignore the macros.

However, I take issue with one point: I seriously doubt that JNJ and PG had the "fortress" balance sheets to survive WW2 had we lost. Volkswagen for sure. KO maybe...at least the formula - Volkstrinken? :-)

"Yankees in Georgia! Oh, how did they ever get in?" - Aunt Pittypat in "Gone With The Wind"

"Why, Confederate bonds, of course." - Gerald O'Hara in "Gone With The Wind"


The Science of Hitting
The Science of Hitting premium member - 4 years ago

You might be right (of course, you could say the same for nearly every other stock as well, correct?) - but for anybody who was alive at that time and was holding stock in JNJ or PG, my guess is that the value of their portfolio probably wouldn't be their biggest concern, even if they had sold everything and moved 100% to cash.

Now think about the flip side, the path where we are today; along the way, there have been plenty of concerns about war, recession, natural disaster, terrorist attacks, etc. In almost all those cases, you could make the same argument; and in some situations, there were serious setbacks for the investor with a short term horizon. Despite this, the long term investor would undoubtedly be much better off having owned a collection of businesses with competitive advantages, rather than cash, over that time period.

"What if" is a good question to ask, especially for what we can actually detect (like accounting fraud or competitive changes in the industry); for macro issues like the ones we are talking about, my personal opinion is that the investor hurts their long term financial success by worrying about that which is unpredictable.

Benethridge - 4 years ago
To me, investing is all about betting on the side of "probability" instead of the side of "possibility". Could America have lost WW2? With a bit of bad luck, yes, but given our strengths, we were "probably" going to win.

"Her industrial might is awesome!" - Admiral Yamamoto

Have you noticed that in your statements above, you are always "looking in the rearview mirror"? What are your thoughts on the long-term (say 20-year) future of America?

If you listen to Buffett in his interviews, he's always optimistic about America's future, and consequently the future of its various businesses, and he gives good reasons for being optimistic. Of course, one could make the argument that he's just trying to influence his own prophesy for somewhat selfish reasons....

...but he "probably" isn't, IMHO and that's what I mean about being "optimistic". I'm betting on the side of the "probable". I'm betting with Buffett on America.

You could make the argument that we're just being "realistic" and I would not disagree....

...but do not be so quick to dismiss the "pessimists". I listen to them with respect but I do not bet with them. They probably are wrong...but with just a teeny bit of bad luck they COULD be right...and that's what's so scary about investing. We COULD all end up like Gerald O'Hara with his Confederate bonds.

"All we've got is cotton and slaves, and arrogance." - Rhett Butler

The Science of Hitting
The Science of Hitting premium member - 4 years ago

I'm looking in the rear view mirror because it says something about certain companies and their ability to grow and prosper (over time) regardless of any short term macroeconomic conditions; that is the point of all I have been trying to say above when I mention prior times of hardship like the Great Depression or the most recent recession.

I'm confident on the U.S. over time, but more confident on the future of emerging markets, where billions of people will enter the middle class over the coming decades and want to use products made by Procter & Gamble, Johnson & Johnson, and PepsiCo. Regardless of any short term issues (like right now, where these companies are balancing a weak developed market consumer and rampant commodity cost inflation), I think the long term opportunity is not the least bit diminished; I've put my money where my mouth is, and have the majority of my portfolio in the three companies mentioned above (along with BRK.B and MSFT).
Benethridge - 4 years ago
I agree. I think we're saying the same thing with different words.


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